Introducing the implied trading range

In past blogs, I have talked about an implied volatility. Probably the most important factor in determining how successful you will be at trading options. In fact, you could argue that implied volatility as a concept is as important to an options trader as say, earnings estimates are to a stock analyst.

The problem with implied volatility it that it is a difficult concept to quantify. Meaning that it means very little in terms of how to apply strategy to a specific situation.

Pricing an exchange-traded option requires the use of a complex mathematical formula. The mathematical model is driven by six basic factors; 1) current price of the underlying stock, 2) strike price of the option, 3) time to expiration, 4) dividends, 5) interest rates and 6) volatility.

Looking at the six components, we know with certainty (or near certainty) what most of the inputs ought to be. We know, for example, exactly what the current price of the stock is. The strike price of the option is part of the option contract. We know precisely when the option contract is set to expire (options expire on the Saturday following the third Friday of the expiration month) and we have a high degree of confidence what interest rates are, and what dividends if any, will be paid by the underlying stock.

What an options price really comes down to is volatility, which is simply the model’s evaluation of risk. In terms of the math, volatility is simply a measure of how much the stock price is expected to vary from its current price. The input into the option pricing formula is the annual standard deviation of the stock’s price.

Problem is, most option traders overlook volatility as a consideration when making investment decisions. Traders will simply buy calls if they are bullish on the outlook for the underlying stock, or buy puts if they are bearish. But if traders pay too much for the calls or the puts, they may find that even though they were right about the direction of the underlying stock, they lose money on the trade.

That the majority of individual option traders lose money over time, speaks to the importance of understanding volatility. What happens, is that investors don’t really have a clear understanding as to when volatility is over or understated. If I say that the options on the S&P TSX 60 iShares (symbol XIU), for example, are implying a volatility of 22%… is that good or bad? Without a point of reference, it is impossible to know.

In the options market, you pay a premium to play the game. The option premium effectively handicaps the underlying market, much like the spread handicaps the wager in a football game.

If I were making a bet on the outcome of a football game, and team “A ” with a record of ten wins and one loss was playing team “B” with a one and ten, won loss record, most of us would expect team “A” to win the game based on their past records.

But if we were to make a bet on the outcome of the football game, and the handicap was 50 points, that would dramatically change the way we would view the outcome. While team “A” might win the game, it is highly unlikely that team “A” will win by more than 50 points. We intuitively know that a 50 point handicap in a football game is too high.

When we make investment decisions we follow a similar process. We make a decision to buy or sell XIU based on its’ history. You may choose to look at specific price patterns on a stock chart, or perhaps use fundamental analysis, or an earnings estimate to make your decision. But the decision to buy or sell is based, in large part, on how the stock or index has historically acted given a specific set of circumstances.

For example, if you we using fundamental analysis, you would buy XIU if your earnings expectation was greater than the markets. And theoretically, you would sell if your earnings estimates were less than the markets. Without using options to play the game, your decision to trade is complete.

However, once we introduce options into the equation, we need to understand how much of a handicap the options market requires us to pay in order to play the game. The handicap is implied volatility.

Unlike the football handicap where we have an intuitive feel, we do not have the same feeling about implied volatility. Is a 22% implied volatility assumption on XIU too high or too low?

One way around this is to put implied volatility into perspective, by defining it as an implied trading range. Without, of course, having to use a spreadsheet to determine the end result.

To deal with this, consider the following approach. We know that XIU recently traded at $77.70. If we look at the XIU June 78 calls, which at the time I looked at them, were trading at $4.00. The XIU June 78 puts were trading at $$4.00.

If we bought the XIU June 78 call and XIU June 78 put, the total cost would be $8.00. At this point, being long a call and a put on XIU, do we care which direction the stock goes? In fact, we don’t care if XIU rises or falls. Only that XIU moves far enough so that we earn more than the total cost for the straddle.

If you were to add the $8.00 cost of the XIU straddle to the strike price of the options, the upside breakeven is $85 and the downside breakeven is $70. That is the trading range that the options market is implying for XIU between now and the June expiration.

The next question is whether you think XIU is likely to breach either end of that trading range between now and the June expiration. If you think that XIU is likely to be above or below the outer boundaries of that implied trading range, then you are effectively saying that the options on XIU are cheap. Or that the volatility being implied by XIU options are understating future volatility.

Similarly, if you think that XIU will not likely breach either end of that trading range between now and the June expiration, you are effectively saying that the options on XIU are expensive.

Now you are in a position to make a proper investment decision using options. Your first step is to decide whether you are bullish or bearish on XIU. If you are bullish, you have choices; you can buy calls or implement an option writing strategy (i.e. a covered call write or a cash secured put).

The latter decision depends on your view as to whether XIU options are over or undervalued. If you are bullish on XIU, and think the XIU options are cheap using the aforementioned techniques, then by all means buy calls. If you think that the options on XIU are expensive, use an option writing strategy to implement your position.

That second step in the investment decision process can go a long ways to ensuring greater success in the options market.